The crisis has highlighted the need for, and difficulties with, a Eurozone banking union. This column argues that, to make a union, you need three crucial ingredients: common supervision, a single resolution mechanism, and common safety nets. The power to control and the resources to rescue must work in parallel. Eurozone leaders have taken the first critical steps, but further progress is needed to strengthen the financial architecture of the single currency.

Before the crisis, the common currency and single market promoted financial integration. Banks and financial institutions operated with ease across countries; credit went where it was in demand; and portfolios became increasingly more diversified. The interbank market functioned smoothly, and monetary conditions were relatively uniform across the Eurozone. There were side effects, such as large capital flows within the Eurozone and the associated buildup of sovereign and private-sector imbalances. But, by and large, a hybrid financial architecture based on a single currency and common market, and national-based financial safety nets, bank supervision and regulation seemed to serve the Eurozone well.

Inherent tensions in institutional design

The crisis laid bare the tensions inherent in this institutional design. Private borrowing costs rose with the sovereign's, imparting procyclicality and impairing monetary transmission. This amplified financial fragmentation (Figure 1) and volatility, and thus exacerbated the economic downturn. This adverse dynamic resulted from the inability to control local interest-rate conditions, and an architecture that strengthened the link between a country’s banking and real sectors and the health of its public finances. In hindsight, it is evident that, in good times, banks grew in many places to a scale that overwhelmed national supervisory capacities, while in bad times, they overwhelmed national fiscal resources. It is also clear that, in the existing architecture, if a sovereign’s finances are sound, then its backstop for its banks is credible. But if they are weak, then its banks are perceived as vulnerable and, therefore, face higher funding costs (Figure 2) (see Acharya et al. 2012, Gerlach, Schulz, and Wolff 2010).

Figure 1. Foreign exposure (€ billions)

Source: BIS consolidated banking statistics, immediate risk basis.

Note: Ireland and Finland not included due to breaks in data reporting.

Figure 2. Bank CDS spreads cluster along country lines during crisis1

Source: Bloomberg and IMF staff calculations

Notes: 1The sample includes all 31 banks in the 2010 EU-wide EBA stress test for which CDS data (end of month) were available in Bloomberg. Available data for Greece in 2012 are not plotted due to being far away from the rest of the sample (the CDS spreads of two Greek bank spreads were 1990 bps and 2027 bps, and the sovereign Greek CDS spread was 8711 bps as of May 2012).

The crisis also brought to the forefront a second tension. Nation-bound regulators may unduly favour a country’s banking system and economy and may not internalise cross-border spillovers, which lie beyond their mandates. In good times, they may not take into account how their actions contribute to the buildup of excesses in other countries. In bad times, they may encourage reducing cross-border activities of their banks, exacerbating financial fragmentation.

Can a banking union help and what should it look like?

In a recent paper (Goyal et al. 2013), we argue that a well designed banking union can help address both tensions. To be effective, the new institutional framework would have to comprise three elements:

A single regulatory and supervisory framework.

A single resolution mechanism.

A common safety net.

All three elements are necessary.

A single supervisory mechanism without a common resolution and safety net framework will do little to break the vicious circle between banks and sovereigns and reestablish a properly functioning monetary transmission mechanism.

In particular, lack of a credible resolution framework would hamper the effectiveness of the single supervisory mechanism and impede timely decision-making by leaving national authorities to deal with the fiscal consequences of others’ supervisory decisions.

Bank recapitalisation as well as resolution and deposit-insurance mechanisms would lack credibility without the assurance of fiscal backstops and burden-sharing arrangements.

Conversely, common safety nets and backstops without effective supervision and resolution would break sovereign-bank links, but risk distorting incentives, reinforcing tendencies for regulatory forbearance, and shifting losses to the Eurozone level.

In short, power and resources must go hand in hand.

Europe is moving in the right direction and (given the institutional constraints) at a commendable speed. Important progress has been made toward establishing a single rule book and a single supervisory mechanism, and the aim is to agree on a framework for a European stability mechanism direct recapitalisation by June 2013 and on a single resolution mechanism that could be in place in 2014. There are of course implementation challenges related to putting into practice effective common supervision. It is essential also to avoid stalling on reforms. In this regard, agreeing on a framework and timetable for common safety nets and backstops is critical.

Is this the solution to the crisis?

Obviously, a banking union will not solve all the Eurozone’s problems. But it can help speed the process of repair. Having common resources deployed through the ESM will help recapitalise and repair banks where the sovereign is weak. To align incentives, proper governance and control must be in place - through supervision at the ECB1. Common supervision will also mitigate regulatory ringfencing. These actions would reduce fragmentation of financial markets, help repair monetary transmission, and facilitate economic recovery.

Looking back, one could also argue that an effective common supervisor would have limited the concentrated exposures of banks to certain risks. For example, Eurozone-wide supervisors would arguably not have allowed size, structure and concentration risks to grow as they did in countries such as Spain, Ireland, or Cyprus. Effective single supervision would take a broader perspective, and would need to counterbalance any tendency of common safety nets to allow imbalances to grow even larger.

How do we get there?

In an ideal world, in tranquil times, the transition to a banking union would be gradual. Most likely, it would start with harmonising supervision, resolution, and safety nets across countries. This would be followed by an agreement on burden sharing and fiscal backstops and with the development of new common institutions. Finally, the process would culminate with the transfer of powers and responsibilities to a full banking union, with a single supervisory mechanism, a single resolution authority, a common resolution and deposit-insurance fund, and common backstops.

But times are far from tranquil. Rapid action is needed, and solutions may temporarily involve risks and costs. Yet, a well defined timetable and agreement on what the banking union would finally look like will minimise the risk of an incomplete and possibly incoherent architecture.

Breaking the sovereign-bank link

Repairing the financial sector and re-establishing a properly functioning monetary-policy transmission mechanism are key elements of any crisis resolution strategy. From that standpoint, the decision by Eurozone leaders to allow the European stability mechanism to recapitalise banks directly is the right one.

To be sure, failing non-systemic banks should be resolved at least cost to national deposit-insurance schemes and taxpayers.

Yet, the issue of potential Eurozone assistance may still arise in relation to frail domestically systemic banks, for which individual sovereigns may not have adequate resources to deal with, lest public solvency be undermined.

A first step is to fully recognise the losses on bank balance sheets. Given that the European stability mechanism cannot make expected losses, a pragmatic solution toward resuscitating frail domestically systemic banks is for the private sector and domestic sovereign to put in as much capital as would make the capital position non negative. The European stability mechanism would top up to meet regulatory requirements, and should stand ready to support the bank for any unexpected losses going forward. In this way, the European stability mechanism’s involvement would delink the sovereign from future unexpected losses on bank balance sheets. By ensuring that the banks have an owner of unquestioned financial strength, it would improve bank funding conditions.

Moral-hazard concerns

The European stability mechanism’s resources should be unlocked as soon as possible. However, the transfer of financial responsibilities to the centre needs to be balanced by the transfer of supervisory power. In that context, the decision to subordinate the European stability mechanism direct recapitalisation to the establishment of an effective single supervision mechanism within the ECB is a sensible one.

Common resolution and safety nets

The single stability mechanism will have to work with national resolution authorities to resolve or restructure weak institutions, until a single resolution authority with common backstops is established. To facilitate the process, there may be merit to establishing a temporary body or creating urgently an EU agency tasked with the coordination of bank crisis management and resolution among national authorities and the ECB. Agreeing on clear principles about the hierarchy of claimants and reducing expectation of bailouts would help contain the fiscal costs of future resolutions, including by allowing the possibility of bailing in uninsured creditors.

Steps should be taken toward true common safety nets to insure risks more efficiently and weaken sovereign-bank links. A re-insurance scheme, for instance, could be created for national deposit-guarantee schemes, funded at the Eurozone level through industry levies and contributions from member states. Ex-ante agreement on the shares of national and supranational funding in depositor payouts would limit moral hazard. Over time, the fund would build administrative capacity, and could be a step toward a permanent deposit-guarantee and resolution fund.

Risks and problem issues

A key risk is that of incomplete or stalled implementation. As discussed above, an effective banking union entails single supervision and regulation, a single resolution mechanism, and common fiscal backstops and safety nets. Therefore, agreement on and implementation of critical design aspects must not be deferred far into the future.

Other transition risks relate to the ability to build adequate capacity at the ECB and establish incentive-compatible relationships between the ECB and national regulators. All this will inevitably take some time. In the meantime, conflicts of interest may lead to supervisory drift. Clarity is thus essential on the responsibilities and accountability of the various supervisory authorities. To limit conflicts and improve communication, the ECB would need quickly to put in place cross-country teams for the supervision of the most systemic or fragile banks. Moreover, it will be important to balance the representation of national interests and public officials from the ECB in the governance structure of the single stability mechanism. There are also concerns about conflicts between the ECB’s traditional objective and its newly acquired responsibility. To address these concerns, consideration could be given to strengthening the governance of the decision-making process and accountability of supervision at the same level as the central banking functions. Finally, because systemic risks may re-emerge in the future as interconnections and size evolve, renewed vigilance and new policy tools (such as those classified as macroprudential) will be required at the ECB.

Conclusion

In conclusion, European policymakers face the daunting task of putting in place a banking union while combating a crisis. They have taken critical steps and made admirable progress. Completing the architecture as summarised above can only augur well for the stability of the monetary union.

Disclaimer: The views expressed here are those of the authors and do not necessarily represent those of the institutions with which they are affiliated.